Capital Rationing and External Discount Rates

THIS PAPER ARGUES that external discount rates are important to a firm operating under capital rationing. This position conflicts with the views expressed by other authors writing in the area, all of whom have rejected external discount rates (see Hirshleifer (6), Baumol and Quandt (1), Charnes, Cooper and Miller (3), Klevorick (9), and Weingartner (12)). Parts I and II discuss Hirshleifer's article (6) and show that when the indifference curves are properly drawn, external discount rates enter the project selection decision for a firm operating under capital rationing. Part III discusses mathematical programming models, the other type of argument against using external discount rates, and shows why external discount rates should also enter the project selection decision in these models.' The major thesis of the paper is that even though a firm may be unwilling to go to the capital market for new funds, the firm is still being valued in that market, and any capital budgeting prescription that ignores the impact of the firm's capital budgeting decision on the current market price is harmful to its stockholders. One caution is in order. There are several possible meanings of capital rationing. For example, when Hirshleifer uses the term capital rationing, he means there are no borrowing opportunities for either individuals or firms.2 In contrast, the more conventional meaning of capital rationing and the one used in this paper is that a firm has no external borrowing opportunities, but the firm's stockholders do have access to capital markets.